Another Southern District of New York (“SDNY”) court has sided with the Securities and Exchange Commission (“SEC”) in its enforcement campaign against the unregistered sale of cryptocurrency assets. On March 27, 2024, in SEC v. Coinbase, Inc., Judge Katherine Polka Failla held that the SEC’s complaint against Coinbase, Inc. (“Coinbase”) plausibly supported its claim that the crypto firm was selling an unregistered security in violation of federal securities law, thus rejecting Coinbase’s motion for judgment on the pleadings.1 This decision comes after two other SDNY courts have already chimed in (and came out differently from each other) on the issue of whether the sale of crypto assets on investment platforms constitutes an investment contract under federal securities law. In SEC v. Ripple Labs Inc., Judge Analisa Torres held that the sale of crypto assets on public marketplaces, under the facts before her, were not the sale of investment contracts under federal securities law.2 However, in SEC v. Terraform Labs Pte. Ltd., Judge Jed Rakoff came down the other way and held that under the facts before him, the sale of crypto assets to retail investors on public marketplaces could be the sale of investment contracts.3 Now, with Judge Failla’s recent decision, the SEC has one more victory under its belt at SDNY.
Coinbase’s Sales of Crypto Assets to Retail Investors and Institutional Investors Were Investment Contracts.
The SEC filed its complaint against Coinbase on June 6, 2023, alleging that Coinbase violated the federal securities laws through, among other things, (i) the sale of crypto assets on its Coinbase Platform, a public marketplace allowing all retail investors to trade crypto assets; (ii) the sale of crypto assets on Prime, Coinbase’s trading platform for institutional customers; and (iii) the use of its Staking Program, where program participants would “stake” their crypto assets to be pooled together by Coinbase with other investors’ crypto assets to then be invested by Coinbase in exchange for certain rewards.
The central question here before Judge Failla was whether each of these three types of transactions involving a particular crypto asset were “investment contracts” for securities law purposes. To answer this question, the Court applied the longstanding test from SEC v. W.J. Howey Co. The Howey test asks whether the assets were sold in transactions where a purchaser “[(1)] invest[ed] his money [(2)] in a common enterprise and [(3)] [was] led to expect profits solely from the efforts of the promoter or a third party.”4
The Court held that the SEC adequately pleaded that each of the three alleged types of transactions could be “investment contracts” and thus subject to federal securities laws. Regarding the sales of assets to investors on both Coinbase Platform and Prime, the Court noted that promoters of the assets “frequently represented that proceeds from crypto-asset sales would be pooled to further develop the [assets’] ecosystems and promised that these improvements would benefit all [asset] holders by increasing the value of the [assets] themselves.” The SEC also adequately pleaded that investors reasonably expected profits from the efforts of Coinbase since “issuers and promoters of [the assets]—through websites, social media posts, investor materials, town halls, and other [forums]—repeatedly encouraged investors to purchase [assets] by advertising the ways in which their technical and entrepreneurial efforts would be used to improve the value of the asset.” Finally, investors could reasonably expect a profit from Coinbase’s efforts since it promoted through public communications that “[asset] issuers would employ deflationary strategies to reduce the total supply of [assets] and thereby affect [that is, “increase”] the [asset] price.”
Like Judge Rakoff in Terraform, here Judge Failla refused to draw a distinction between an institutional investor trading directly with the issuer and retail investors on the secondary market, noting “there is little logic to the distinction [Coinbase] attempt[s] to draw between the reasonable expectations of investors who buy directly from an issuer and those who buy on the secondary market.” To the Court, all investors are “attracted by the promises and offers made by issuers to the investing public.”
Coinbase’s Staking Program Is Also Subject to Federal Securities Law
According to the court, the SEC also plausibly alleged that Coinbase could have violated federal securities law through the use of its Staking Program, where “customers’ crypto-assets are transferred to and pooled by Coinbase and subsequently ‘staked’ by Coinbase in exchange for rewards.”5 The Court held that this “staking” service was adequately pleaded as an investment contract. Staking participants had reasonably expected to profit from Coinbase’s management of the program, since Coinbase had promised investors it would undertake significant and technical managerial efforts. Further, the Court noted that Coinbase’s own marketing materials implicitly represented these managerial efforts, saying that “staking” is “confusing, complicated, and costly” but that through the Staking Program, Coinbase is “changing all that.” Another statement claimed that “staking your own crypto is a challenge . . . [but] [o]n Coinbase, we do all this for you.” To the Court, readers of these statements could reasonably rely on the promoter’s effort to generate profits.
The SEC Did Not Violate Coinbase’s Due Process Rights or the Major Questions Doctrine
At the start of its opinion, the Court also rejected Coinbase’s argument that the SEC’s enforcement action violated the Due Process Clause by failing to provide “fair notice” of what conduct is required or proscribed by the law. In so holding, the Court pointed to the “broader timeline of the SEC’s positions . . . [which] reveal[ed] that the SEC provided Coinbase (and similarly situated actors) fair notice — through written guidance, litigation, and other actions — that the sale or offering of crypto-assets could prompt an enforcement action by the SEC.”
Further, the Court rejected any argument that the SEC’s complaint violated the Major Questions Doctrine, which requires the “agency [to] point to ‘clear congressional authorization’ in the ‘extraordinary’ case where it claims the ‘power to regulate a significant portion of the American economy’ that has ‘vast economic and political significance.’”6 To the Court, the crypto industry fell short of meeting that high, rarely invoked standard, noting that many different securities industries over which Congress has given SEC the enforcement authority are even broader and more loosely related to typical securities than the market for crypto is. Further, it reasoned that the SEC is not wielding some new, transformative power not previously used under the relevant securities law, but rather merely applying its enforcement authority on another instrument (here, a crypto asset) that might be sold as an investment.
The Split in Authority Continues
As the SEC continues to bring enforcement actions against the crypto industry, we can expect more and more lower courts to continue to iron out this split in the jurisprudence on whether the sale of crypto tokens on public exchanges constitutes an investment contract under federal securities law. Accordingly, crypto investors and industry participants should continue to monitor this ever-evolving area of law for any future developments.
1Opinion and Order, SEC v. Coinbase, Inc., No. 1:23-cv-04738-KPF (S.D.N.Y. Mar. 27, 2023), Dkt. No. 105.
2SEC v. Ripple Labs, Inc., 20 Civ. 10832 (AT), 2023 WL 4507900 (S.D.N.Y. July 13, 2023).
3SEC v. Terraform Labs Pte Ltd., No. 23-cv-1346 (JSR), 2023 WL 4858299 (S.D.N.Y. July 31, 2023).
4SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).
5A more thorough description of “staking” as a crypto-asset service can be found at Rebecca Fike & Eli Sterbcow, A Stake in the Ground? — What the SEC’s Settlement With Kraken Tells Us About the Future of Crypto Regulation and Enforcement, V&E Insight (Feb. 27, 2023), https://www.velaw.com/insights/a-stake-in-the-ground-what-the-secs-settlement-with-kraken-tells-us-about-the-future-of-crypto-regulation-and-enforcement/.
6Opinion and Order, supra note 1, at 32 (quoting Util. Air. Regul. Grp. V. EPA, 573 U.S. 302, 324 (2014)).
